In my ongoing research on valuation, I constructed a quarterly P/E series for the S&P 500 based on reported earnings from Q4-1935 through Q3-1988, and operating earnings since then. Its average is exactly 15.0. It was 18.5 during Q1-2015. It has been this high before and sometimes gone higher. A reversion-to-the-mean valuation model is bearish based on this measure of the P/E since it is currently higher than its mean.

Over 30 years ago, Jim Moltz, my mentor at CJ Lawrence during the 1990s, devised the Rule of 20. It states that for equities to be fairly valued, the P/E ratio plus the inflation rate has to be around 20. In April, the CPI inflation rate was minus 0.2% y/y, implying that the fair-value P/E should be 20.2, well above the trailing P/E. On the other hand, the core CPI was up 1.8% y/y, suggesting that 18.2 is the right valuation number.

Greg Donaldson, the chief investment officer of Donaldson Capital Management and a subscriber and friend of Yardeni Research, offers an interesting inflation-based analysis of the P/E in a 5/16 Seeking Alpha article titled "The Great P/E Debate: Are Stocks Overvalued?" Greg writes: "We do not find strong relationships between any of the widely followed indicators such as interest rates, GDP growth or earnings growth. We have found that inflation is the best predictor of P/E ratios at any given point in time." He ran a regression of inflation (using the core PCED) on the earnings yield (E/P). He used it to calculate that the current P/E should be about 21 based on his model.

In addition to tracking the trailing P/E, I also monitor market-capitalization-to-sales and price-to-sales ratios. During Q1, the Fed's Financial Accounts showed that the ratio of the market capitalization of all equities traded in the US (excluding foreign issues) to nominal GDP rose to 1.69, the highest since Q3-2000. The comparable ratio for the S&P 500 rose to 1.87 during Q1, also the highest since Q3-2000. The ratio of the S&P 500 to its forward revenues per share rose to a cyclical high of 1.82 in early June. Stocks are seriously overvalued according to these measures.

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